The Fed is Further Fueling the Bond Bubble

July 29, 2019

Let’s dive right into why lowering interest rates at this point in the cycle will not provide much of a boost to the faltering global economy and may not be much help to the stock market either. The simple truth is that asset prices are far too overvalued and debt levels far too onerous for a few rate cuts—for which Wall Street has already priced into the market–to make much of a difference. The European Central Bank (ECB), Bank of Japan (BOJ), and Fed don’t have room left any longer to play the same trick they have played since 1987. Namely, whenever there has been a hiccup in the stock market or the economy, they drop borrowing costs by at least 5%. But now there is zero room left in Europe and Japan, and just over 2% here in the US to reduce borrowing costs.

The proof can be found in the real estate market. By persistently forcing interest rates down, the Fed has engendered another bubble in home prices that has simply pushed them far above the affordability level for first-time buyers. Existing Home sales are down 2.2% from the year-ago period in June. Permits to build more homes, meanwhile, sank 6.1% month/month in June and were also about 7% lower compared to the same month last year. However, the 30-year fixed mortgage rate dropped to about 3.75% during the month of June, from a peak of 4.94% last November, according to data from mortgage finance agency Freddie Mac. This is proof that what the housing market needs to attract new buyers is much lower prices, not a few basis points lower in mortgage rates.

I want to share with you some disturbing data that was published by the highly respected personal finance company called Wallet Hub that doesn’t offer much hope for the immediate future regarding the affordability, or lack thereof, for first-time home buyers. Today, about one in nine individuals between the ages of 16 and 24 are neither working nor attending school. And, more than 70% of these young adults are ineligible to join the U.S. military because they fail academic, moral, or health qualifications.

Turning to the health of US corporations and the broader economy, a good barometer can be found in the railroad industrial giant CSX. The company reported earnings recently that missed on both the top and bottom line. And here’s what the CEO had to say about the condition of the economy:

“Both global and U.S. economic conditions have been unusual this year, to say the least, and have impacted our volumes. You see it every week in our reported carloads,” Chief Executive James Foote said on a conference call following the earnings report. “The present economic backdrop is one of the most puzzling I have experienced in my career.” Mr. Foote’s career in the railroad industry is over 40 years. The stock plummeted 12% on the news in one day.

While the data on Retail Sales was a bit better than some of the gloom coming from corporate earnings reports for Q2, GDP growth still dropped from 3.1% in Q1, to just 2.1% this quarter.

Regrettably, the data on global GDP growth is much worse. Auto sales in the European Union (EU) dropped by 7.9% in June from the same month a year ago. And exports from Singapore fell for the 4th month in a row and were down an astonishing 17.3% in June from the same month in 2018. The nation’s exports of electronics plummeted by 31.9% year/year. Germany’s manufacturing sector worsened in July with goods producer performance falling to its lowest level in seven years.

I want to highlight some comments made in a recent interview by one of the Fed’s chief lovers of counterfeiting, Charles Evans, President of the Chicago Fed. It is crucial to understand to what degree these central planners are hell-bent on destroying the middle class in favor of Wall Street. Mr. Evans was very clear that having an inflation rate that is even a few basis points below its asinine 2% target must be “rectified” as soon as possible and for a very long time. In other words, some members of the FOMC believe inflation must be forced well above 2% for many years to make up for the years the Core PCE Index spent below 2%. Core PCE Inflation is the Fed’s preferred metric for measuring inflation and is by far the lowest measure concocted by the government. Nevertheless, because this measurement of inflation is a measly three tenths below target, the FOMC may be panicking towards the zero-bound level once again.

The world’s central bankers have redefined stable prices as a 2% annual rate of inflation. Mr. Evans now says, “We need to go above 2% at some point or else I’m worried that [investors will think] that 2% certainly looked like a ceiling didn’t it” In other words, the Fed thinks it is imperative to empirically demonstrate to everyone that it can bring inflation above 2% “with confidence”.

The truth behind why the Fed is so concerned about maintaining a 2% inflation target is that it knows banks’ assets are in a bubble and the financialization of the economy requires that the central bank keep asset prices from ever correcting. This is because the bubbles are so big that an innocuous burst is no longer possible. Even a small decline in asset prices could quickly spiral into a crash and take the entire economy down with it.

Despite the perennial “better than expected” game Wall Street loves to play, year over year earnings growth has been pitiful. BASF, FAST, TXT, NFLX, CSX and CAT are just some of the tape bombs that we have seen. In some cases, their shares plunged by double digits just seconds after the new release. CAT dropped by 5% after missing on earnings and revenue and lowered guidance. There have been a plethora of industrials and transportation companies whose terrible earnings show how weak the global economy has become. Indeed, not all earnings have been bad and most, as they always do, have beat lowered expectations. But the truth is that global growth is slowing—the IMF recently lowered its growth forecast again; this time to the lowest level since 2009. For now, it may be the case that Wall Street doesn’t care because the Fed is expected to cut rates and force more people to chase in an unhedged fashion further into this dangerous bubble.

But it will take a massive stimulus package from the Fed, ECB, BOJ, and PBOC to push the economy from disinflation to stagflation, which may levitate asset prices a bit longer. The sad truth is that such fiscal and monetary madness is definitely on its way at some point. We’ll learn more about this on July 31st after the FOMC’s rate decision. Perhaps a 50-bps rate cut and the end of the Quantitative Tightening (QT) would do the trick. But that will just severely weaken the foundation for the market and economy, just as it intensifies the inflation central banks have been so aggressively trying to construct.

The problem with the global economy does not stem from borrowing costs that are too high. In fact, interest rates are already at an all-time low. Therefore, lowering interest rates cannot at all fix the economy. It will just create more imbalances and further undermine what’s left of the middle class.  And eventually, ensure the coming interest rates shock will obliterate the stock bubble that has been built on free money.